Definition
A Stop Order (also known as a stop-loss order) is a directive given to a securities broker to buy or sell a security at the market price once the security has traded at a specific price, referred to as the stop price. It is a type of market order that is activated once the stop price has been reached.
Examples
- Example 1: An investor buys shares of a company at $50 per share. To limit potential losses, the investor places a stop order to sell if the stock price falls to $45. If the stock drops to $45, the stop order becomes a market order and the shares are sold at the next available market price.
- Example 2: A trader owns a stock currently priced at $100 per share and expects its value to rise. To protect potential profits, they set up a stop order at $90. If the stock experiences a sudden drop to $90, the order instructs the broker to sell immediately, securing the profit from the drop’s outset.
Frequently Asked Questions
1. What is the primary purpose of a stop order?
The primary purpose of a stop order is to protect an investor’s profits or limit their losses by triggering a market order when the stop price is reached, ensuring immediate market execution.
2. How does a stop order differ from a limit order?
A limit order specifies the maximum or minimum price at which an investor is willing to buy or sell a stock, while a stop order becomes a market order to buy or sell once the stop price has been reached.
3. Can a stop order guarantee execution at the stop price?
No, a stop order does not guarantee execution at the stop price. Once the stop price is reached, it becomes a market order and is executed at the best available price, which may be higher or lower than the specified stop price.
4. Are there different types of stop orders?
Yes, there are mainly two types: a stop-loss order (to sell once a lower price is reached) and a stop-buy order (to buy once a higher price is reached).
5. When is it advisable to use a stop order?
It is advisable to use a stop order when an investor wants to limit their losses on a holding they own or ensure they miss out on potential profit erosion by buying into a security at a specific upside price point.
- Market Order: An order to buy or sell a security immediately at the best available current price.
- Limit Order: An order to buy or sell a security at a specific price or better.
- Stop-Limit Order: A combination of a stop order and a limit order, which becomes a limit order once the stop price is reached.
- Trailing Stop Order: An order set at a predefined percentage away from the current market price, adjusting as the price changes.
Online References
Suggested Books for Further Studies
- “Trading and Exchanges: Market Microstructure for Practitioners” by Larry Harris
- “A Beginner’s Guide to Stock Market: Learn The Basics of Stock Market” by John Border
- “Trading for a Living: Psychology, Trading Tactics, Money Management” by Dr. Alexander Elder
Fundamentals of Stop Orders: Securities Trading Basics Quiz
### What is the primary purpose of a stop order?
- [ ] To lock in profits indefinitely
- [x] To protect a profit or limit a loss
- [ ] To guarantee the stock will reach a certain price
- [ ] To buy or sell at a fixed price
> **Explanation:** The primary purpose of a stop order is to protect a profit or limit a loss by instructing a broker to buy or sell a security once it hits a specific stop price.
### How does a stop order differ from a market order?
- [ ] A stop order is executed immediately regardless of the price.
- [x] A stop order becomes a market order after reaching the stop price.
- [ ] A stop order guarantees execution at a stop price.
- [ ] A stop order has no relation to market execution.
> **Explanation:** A stop order becomes a market order once the stop price has been reached, activating immediate market execution but not guaranteeing the stop price.
### What happens when the stop price of a stop order is met?
- [x] The order becomes a market order.
- [ ] The order is canceled.
- [ ] The order is reset to a new stop price.
- [ ] The order remains inactive.
> **Explanation:** When the stop price is met, the stop order becomes a market order, triggering immediate execution at the best available current price.
### Is it possible to guarantee execution at the exact stop price with a stop order?
- [ ] Yes, always.
- [x] No, the execution price may be higher or lower.
- [ ] Only if it is a stop-limit order.
- [ ] Execution price is irrelevant.
> **Explanation:** A stop order does not guarantee execution at the exact stop price, as it becomes a market order and is executed at the best available price, which may differ.
### What type of stop order is set to buy once a higher price is reached?
- [ ] Stop-loss order
- [x] Stop-buy order
- [ ] Trailing stop order
- [ ] Limit order
> **Explanation:** A stop-buy order is set to buy a security once the price reaches a higher specified stop price.
### Can you use a stop order to buy a security?
- [x] Yes, a stop-buy order.
- [ ] No, only to sell.
- [ ] Yes, but only in volatile markets.
- [ ] No, it is not intended for buying.
> **Explanation:** Yes, a stop-buy order can be set to purchase a security once it reaches a higher specified stop price.
### What is the difference between a stop order and a stop-limit order?
- [ ] A stop order has no limit.
- [ ] A stop-limit order guarantees a profit.
- [x] A stop-limit order becomes a limit order after reaching the stop price.
- [ ] There's no difference.
> **Explanation:** A stop-limit order becomes a limit order once the stop price is reached, pegging the execution to a range instead of immediate market execution.
### When is a stop order particularly advisable?
- [ ] During times of market stability.
- [x] To limit potential losses or protect profits.
- [ ] To avoid paying brokerage fees.
- [ ] When holding indefensible stock positions.
> **Explanation:** A stop order is particularly advisable when wanting to limit potential losses or protect profits from market downturns or unexpected price movements.
### What type of order adjusts according to market price deviations?
- [ ] Fixed stop order
- [x] Trailing stop order
- [ ] Ceiling stop order
- [ ] Non-contingent order
> **Explanation:** A trailing stop order adjusts the stop price based on a predefined percentage from the current market price, trailing the stock price as it changes.
### How does a trader protect profits from unexpected price drops?
- [ ] By continuous manual stock monitoring
- [x] By setting stop orders
- [ ] By diversifying too broadly
- [ ] By avoiding the use of any orders
> **Explanation:** By setting stop orders, traders can automatically protect profits by selling stocks when their price drops below a predetermined stop price.
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